Tuesday, 2 April 2013

Earnings - and dividend yields as of 1 April 2013
Based on the closing price of the S&P 500 index of 1,562.17 on 1 April 2013 and data from Professor Robert Shiller's home page, the current 10-year earnings- and dividend yields for the S&P 500 index are as follows (please refer to the June 2012 analysis for background information):

The 10-year rolling earnings yield was 4.32% as of 1 April 2013 compared to the average since 1978 of 5.95%. The current earnings yield is therefore 27.45% lower than the long term average. The 10-year rolling dividend yield of 1.67% as of 1 April was 37.18% lower than the longer term average of 2.66% and the lowest since June 2006. Removing the 1998 to 2000 period, a period when the stock market was extraordinarily high compared to fundamentals, the current earnings yield is 31.23% lower than average while the current dividend yield is 40.32% lower on the same basis. The current earnings- and dividend yields therefore indicate the S&P 500 index is substantially higher valued now than average.

The Spread as of 1 April 2013
The spread, the difference between earnings yield and the 10-year treasury yield (GS10), was 2.45% as of 1 April. The spread still remains considerable higher than the average negative spread of 0.90% since 1978. One (of many) likely reasons for this, as reported many times before, is that bond yields are artificially low due to the support from the Fed through keeping the Federal funds rate close to zero and buying treasury and mortgage-backed securities. In a historical perspective, the spread indicates the current market valuation of the S&P 500 index is substantially lower than average and that equities as measured by the S&P 500 index appears attractively valued compared to 10-year treasuries.

Conclusion
The S&P 500 index has now increased 9.5% this year and the index has as a result moved further into overvalued territory compared to historical earnings- and dividend yields as we have argued in earlier editions of this monthly report. Last Thursday, the index hit a new all-time high, closing the day on 1,569.2. The S&P 500 to 10-year rolling GDP ratio is currently 11.7% higher than the average since 1957 and the highest since end of Q2 in 2008. At the same time, the Dow Jones Industrial Average and ten of the Wilshire indexes, including the Wilshire U.S. REIT index, also hit new all-time highs (on a week ending basis) on Friday 29 March. For example:

The Wilshire 4500 Total Market Index is now 27.3% higher than its pre-crisis peak (pre September 2008) having increased 13.6% alone this year and 15.6% during the last 12 months.

Finally, the ratio of the Wilshire 4500 Total Market Index (which excludes the 500 stocks in the S&P 500 index) to GDP also indicate the U.S. stock market based on this index is now receiving record valuations:

Wilshire 4500 divided by GDP for the last four quarters are now the highest ever recorded based on data going back to 1984. At the current 0.080%, the ratio is even higher than the previous all-time high of 0.073% at the end of 1999 (the final stages of the dot com bubble).

Wilshire 4500 divided by the most recent quarterly GDP (Q4 2012) is also higher than the previous all-time high which was also recorded at the end of 1999.

Wilshire 4500 divided by the 10-year rolling GDP is now within a whisker of the record high set at the end of 1999.

As the examples above attempt to highlight, the U.S. stock market in general is now expensive in a historical perspective. For the long term stock market investor, this means the returns over the next couple of years could be (significantly) lower than average with a significant probability of loss. For example, following the peak in the Wilshire 4500 index in Q1 2000, the index dropped some 43% before hitting the bottom three years later. Read for example Shiller P/E is Signaling Risk of Another Lost Decade for US Stocks that describes in some detail the relationship between P/E ratios (the inverse of the earnings yield) and future returns.

Yes, stocks are currently cheap compared to U.S. treasuries based on the spread discussed above and yes, the Fed will continue printing money and trying to keep interest rates low for the foreseeable future. But, the reason for the relatively high spread is more about treasuries being overvalued as receiving less than 2% for owning U.S. treasuries in a country with a 103.7% debt-to-GDP ratio is hardly a risk-free investment. And chances are interest rates will not stay this low forever. The stock market could very well continue to climb upwards in the coming months as new-high headlines could add fuel to the current momentum, but eventually investors will once again start worrying about valuations. They normally do. And when they do the stock market will most likely fall or at best deliver dismal returns.